HSW Advisors MLP Quarterly Review Q4 15:

Transcription

1 HSW Advisors MLP Quarterly Review Q4 15: What To Do With Midstream MLPs Now By Richard Steinberg, Managing Director, Partner After what has been the worst 18 month period in midstream master limited partnership (MLP) history, the main question investors are asking themselves is what do I do now? Although tax loss harvesting and forced selling to deleverage by Closed-End funds created technical supply, the unrelenting correlation to a declining crude oil price has continued to push the MLP group down since the beginning of the year. Fundamentals have been ignored as investors abandoned the asset class after assuming that the commodity price decline would have a debilitating effect on actual cash flow results. With many energy-related companies announcing billion dollar losses or earnings declines within the 50% to 80% range, the midstream MLP group has once again proven the resiliency of the business model by producing business as usual earnings reports. There is no doubt that significant headwinds persist such as slower growth, access to capital and counter-party risk but by and large, the best positioned companies are showing an ability to navigate through this treacherous environment relatively well. At the very least, recent earnings results highlight that midstream MLPs have better cash flow visibility than their energy producing counterparts regardless of similar stock price performance. The disconnect between market perception and actual underlying business fundamentals is what

2 leads my team and me to believe that the current opportunity in midstream MLPs is as attractive as we have seen over the past 15 years. I understand the pervasive negativity toward the energy industry, but it is important to remember that not all segments will be impacted in the same way by lower commodity prices. There are portions of the energy food chain that have and will hold up better than others. The market has assumed that midstream MLPs will see a loss of cash flow similar to that of direct commodity producers, but this assumption is not supported by the facts. Recent earnings reports from leading companies like Enterprise Products (EPD), Magellan Midstream (MMP) and Buckeye Pipeline (BPL) highlight strong results and a benefit from increased utilization of assets due to lower prices. This further stimulates demand for refined products and natural gas. Not all midstream MLPs are created equal and there are a number of gathering and processing companies that have more direct exposure to volume/price and have seen their results impacted negatively. Although there have been a few companies that have cut their cash distributions, I continue to believe that this will be the exception and not the rule. Many of the announced cuts are due to issues specific to companies associated with elevated debt levels, no access to capital and sizeable growth capital spending plans. A number of companies have taken proactive measures to improve their balance sheets and reduce capital spending in order to protect current distribution and to position themselves to benefit when the environment becomes more positive.

3 The reasoning behind the material decline in midstream unit prices is varied and goes well beyond higher short-term correlation to crude oil. Fears over massive volume declines seem overstated when the crude oil rig count is down by 74% since its peak in October 2014, but overall oil production is down by only 7% from the peak in March Natural gas production has continued to rise in the face of price declines during the last six years. Commodity price declines typically stimulate demand. Gasoline demand is up 7% since energy price declines began in June 2014, natural gas demand has continued to grow as it displaces dirtier coal and Natural Gas Liquids (NGL) demand is set to grow as new chemical plants on the Gulf Coast benefit from secure and ample cheap raw material feedstock such as ethane and propane. There is no doubt that lower crude oil production will impact some midstream asset utilization in less attractive basins. However, U.S. oil producers continue to get more efficient and lower their breakeven production price, which should help volumes from falling more dramatically. I don t know anyone who can consistently predict oil prices, but it would appear that the global supply/demand imbalance will be more muted as we move through If there are no major surprises to demand then we expect a more stable price environment by year end. U.S. shale is becoming some of the most economic basins on the globe after significant efficiency and cost improvements. Midstream MLPs don t require a sharp increase in commodity prices to function; it s just that some price stabilization would go a long way to healing the public perception surrounding the group. One major concern for midstream assets is the counter-party risk behind the contracts that support MLP cash flows. The first question on most earnings calls these days has focused on the credit ratings of counter-parties and exposures to nefarious credits. The negative assumption that has emerged is that many energy producers will declare bankruptcy and subsequently, the contracts they signed for the critical infrastructure needed to get their hydro-carbons to market would be thrown out. If that were the case, then the resulting fear is that midstream companies will lose the cash flow expected from those assets thus making it more difficult to pay their distributions. While every bankruptcy situation is unique, the facts do not support even the most draconian assumptions. The reality is that even after a bankruptcy filing, hydro-carbons continue to flow from the well-head. Lenders want to maximize the value of the impaired company so they need to have oil and natural gas produced and sold to generate cash flow. The only way that those hydro-carbons get to market is through the infrastructure assets that were contracted. It is very difficult, if not impossible, to disconnect a pipe at the well head and bring new infrastructure in at a lower cost. The pipeline is often viewed as a critical provider to the energy company allowing them to get their products to the best markets in order to maximize their value. Certainly, there will be efforts to renegotiate some contracts to lower fees, but the midstream companies usually secure additional volumes to create a cash flow neutral transaction. Not all renegotiations will be neutral and some contracts will succumb to

4 bankruptcy, but the wide spread expectation of massive cash flow losses is hyperbolic in our view as it is not supported by the facts. As mentioned earlier, many midstream MLPs earnings results have been reported recently and most have been relatively boring boring being a good thing. Reported EBITDA and distributable cash flow have generally been in line with expectations as have cash distribution announcements. Forward guidance decreased slightly, but nowhere near reflects the magnitude of declines experienced by unit prices. Stock price performance for this group has been as bad as or worse than direct commodity producers and the commodity itself. While negative psychology and outright panic have inflicted tremendous pain, the actual fundamental results have proven to be quite resilient. We fully understand the headwinds facing the energy complex and recognize that growth rates are declining, balance sheets are more stretched, access to capital is difficult and negative headlines will persist, but with current valuations historically attractive and evidence supporting a resilient business model we would not yield to the emotion of the moment. Although it is next to impossible to call a bottom and we fully expect volatility to continue, the current valuation discount coupled with solid operating results lead us to believe this is an attractive buying opportunity. We had hoped that the change of the calendar would be helpful to the group, but it is clear that some stability in the underlying commodity price will be required to improve the negative psychology surrounding midstream MLPs. In the interim, we expect the best positioned companies to continue to deliver satisfactory fundamental results, which should position them for a rebound when the tide turns. We are as frustrated as any investor with how the group has performed, but prefer to take the view of what do we do now? Our answer is to continue to own the best positioned names and add selectively and strategically based on market weakness Richard Steinberg Managing Director, Partner HSW Advisors 505 Fifth Avenue, 14th Floor New York, New York Office Toll Free Fax hswadvisors@hightoweradvisors.com

5 HSW Advisors is a team of investment professionals registered with HighTower Securities, LLC, member FINRA, MSRB and SIPC & HighTower Advisors, LLC a registered investment advisor with the SEC. Securities are offered through HighTower Securities, LLC, and advisory services are offered through HighTower Advisors, LLC. Investments involve risk, including the possible loss of entire investment principal. Past performance is not indicative of current or future performance and is not a guarantee. The information provided is as of the date referenced. HSW Advisors has obtained all market prices, data and other information from sources believed to be reliable, although their accuracy or completeness cannot be guaranteed. Such information is subject to change without notice. The securities mentioned herein may not be suitable for all investors and there is no guarantee that the investment process described herein will be profitable. Before investing, consider the investment objectives, risk, charges and expenses. Diversification does not insure against loss.